In August 2012, the ECB president, Mario Draghi, said that the ECB would ‘do whatever it takes‘ to hold the single currency together and support the weaker economies, such as Greece, Portugal and Spain. At the same time, he announced the introduction of outright monetary purchases (OMTs), which would involve purchasing eurozone countries’ bonds in the secondary markets. There were no limits specified to such purchases, but they would be sterilised by the sale of other assets. In other words, they would not increase the eurozone money supply. But despite the fanfare when OMTs were announced, they have never been used.
Today, the eurozone economy is struggling to grow. The average annual growth rate across the eurozone is a mere 0.5%, albeit up from the negative rates up to 2013 Q3. GDP is still over 2% below the peak in 2008. Inflation is currently standing at 0.8%, well below the 2% target. The ECB’s interest rate (‘main refinancing operations rate’) is 0.25%.
The recovery is hindered by a strong euro. As the chart shows, the euro has been appreciating against the dollar. The euro exchange rate index has also been rising. This has made it harder for the eurozone countries to export.
So what can the ECB do to stimulate the eurozone economy? Other central banks, such as the Bank of England, the US Federal Reserve and the Bank of Japan have all had substantial programmes of quantitative easing. The ECB has not. Perhaps OMTs could be used without sterilisation. The problem here is that there are no eurozone bonds issued by the ECB and hence none that could be purchased, only the bonds of individual member countries. Buying bonds of weaker countries in the eurozone would be seen as favouring these countries and might create a moral hazard.
Reducing interest rates is hardly an option given that they are at virtually zero already. And expansionary fiscal policy in the weaker countries has been ruled out by having to stick to the bailout conditions for these countries, which require the pursuit of austerity policies.
One possibility would be to intervene in the foreign currency market by buying US and other countries’ bonds. This would drive down the euro and provide a stimulus to exports. This option is considered in the Jeffrey Frankel article.
Articles
Why the European Central Bank should buy American The Guardian, Jeffrey Frankel (13/3/14)
Draghi holds course in face of deflation threat Reuters, Paul Carrel and Leika Kihara (13/3/14)
ECB’s Draghi: Strong Euro Pulling Down Euro Zone Inflation Wall Street Journal, Christopher Lawton and Todd Buell (13/3/14)
Draghi Bolstering Guidance Seen as Convincing on Rates Bloomberg, Jeff Black and Andre Tartar (13/3/14)
ECB president Mario Draghi counters euro upswing Financial Times, Claire Jones (13/3/14)
Turning Japanese? Euro zone exporters must hope not Reuters, Neal Kimberley (14/3/14)
Prospect of ECB QE drives eurozone bond rally Financial Times, Laurence Mutkin (12/3/14)
Data
Statistical Data Warehouse ECB
Winter forecast 2014 – EU economy: recovery gaining ground European Commission: Economic and Financial Affairs DG
AMECO online European Commission: Economic and Financial Affairs DG
Questions
- Why is the ECB generally opposed to quantitative easing of the type used by other central banks?
- What is meant by ‘sterilisation’? Why does sterilisation prevent OMTs being classed as a form of quantitative easing?
- Would it be possible for OMTs to be used without sterilisation in such as way as to avoid a moral hazard for the highly indebted eurozone countries?
- Is the eurozone in danger of experiencing deflation?
- What are the dangers of deflation?
- Why does the ECB not cut its main refinancing rate below zero?
- If the ECB buys US bonds, what effect would this have on the euro/dollar exchange rate?
- Would purchasing US bonds affect the eurozone money supply? Explain.
- What other means are there of the ECB stimulating the eurozone economy? How effective would they be likely to be?
With the publication of the February 2014 Inflation Report the Bank of England has adjusted its forward guidance to the markets.
As we saw in Part 1 of this blog, the economy should soon fall below the 7% unemployment threshold adopted in the original forward guidance issued last August. But the Bank feels that there is still too much slack in the economy to raise interest rates when unemployment does fall below 7%.
The Bank has thus issued a new vaguer form of forward guidance.
The MPC’s view is that the economy currently has spare capacity equivalent to about 1%–1½% of GDP, concentrated in the labour market. Around half of that slack reflects the difference between the current unemployment rate of 7.1% and an estimate of its
medium-term equilibrium rate of 6%–6½%. The remaining slack largely reflects a judgement that employees would like to work more hours than is currently the case. Companies appear to be operating at close to normal levels of capacity, although this is subject to some uncertainty.
The existence of spare capacity in the economy is both wasteful and increases the risk that inflation will undershoot the target in the medium term. Moreover, recent developments in inflation mean that the near-term trade-off between keeping inflation close to the target and supporting output and employment is more favourable than at the time the MPC announced its guidance last August: CPI inflation has fallen back to the 2% target more quickly than anticipated and, with domestic costs well contained, is expected to remain at, or a little below, the target for the next few years. The MPC therefore judges that there remains scope to absorb spare capacity further before raising Bank Rate.
Just what will determine the timing and pace of tightening? The Bank identifies three factors: the sustainability of the recovery; the extent to which supply responds to demand; and the evolution of cost and price pressures. But there is considerable uncertainty about all of these.
Thus although this updated forward guidance suggests that interest rates will not be raised for some time to come, even when unemployment falls below 7%, it is not at all clear when a rise in Bank Rate is likely to be, and then how quickly and by how much Bank Rate will be raised over subsequent months. Partly this is because of the inevitable uncertainty about future developments in the economy, but partly this is because it is not clear just how the MPC will interpret developments.
So is this new vaguer forward guidance helpful? The following articles address this question.
Articles
Bank of England Governor Carney’s statement on forward guidance Reuters (12/2/14)
Why has Mark Carney tweaked forward guidance? The Telegraph, Denise Roland (12/2/14)
Interest rates: Carney rips up ‘forward guidance’ policy Channel 4 News (12/2/14)
Forward guidance version 2: will the public believe it? The Guardian, Larry Elliott (12/2/14)
Mark Carney adjusts Bank interest rate policy BBC News (12/2/14)
Mark Carney’s almost promise on rates BBC News, Robert Peston (12/2/14)
Did the Bank of England’s Forward Guidance work? Independent, Ben Chu (2/2/14)
Forward Guidance 2.0: Is Carney just digging with a larger shovel? Market Watch, The Tell (12/2/14)
The U.K. Economy: Five Key Takeaways Wall Street Journal, Alen Mattich (12/2/14)
Bank of England pages
Inflation Report, February 2014 Bank of England (12/2/14)
Monetary Policy Bank of England
MPC Remit Letters Bank of England
Forward Guidance Bank of England
Questions
- Summarize the new forward guidance given by the Bank of England.
- Why is credibility an important requirement for policy?
- What data would you need to have in order to identify the degree of economic slack in the economy?
- Why is it difficult to obtain such data – at least in a reliable form?
- What is meant by the ‘output gap’? Would it be a good idea to target the output gap?
- Is it possible to target the rate of inflation and one or more other indicators at the same time? Explain.
Although the Monetary Policy Committee (MPC) of the Bank of England is independent in setting interest rates, until recently it still had to follow a precise remit set by the government. This was to target inflation of 2% (±1%), with interest rates set to meet this target in 24 months’ time. But things have changed since the new Governor, Mark Carney, took up office in July 2013. And now things are not so clear cut.
The Bank announced that it would keep Bank Rate at the current historically low level of 0.5% at least until unemployment had fallen to 7%, subject to various conditions. More generally, the Bank stated that:
The MPC intends at a minimum to maintain the present highly stimulative stance of monetary policy until economic slack has been substantially reduced, provided this does not entail material risks to price stability or financial stability.
This ‘forward guidance’ was designed to provide more information about future policy and thereby more certainty for businesses and households to plan.
But unemployment has fallen rapidly in recent months. It fell from a 7.7% average for the three months May to July 2013 to 7.1% for the latest available three months (September to November 2013). 
And yet there is still considerable slack in the economy.
It now, therefore, looks highly unlikely that the MPC will raise Bank Rate as soon as unemployment falls below 7%. This then raises the question of how useful the 7% target has been and whether, if anything, it has created further uncertainty about future MPC decisions.
The following still appears on the Bank of England website:
The MPC intends at a minimum to maintain the present highly stimulative stance of monetary policy until economic slack has been substantially reduced, provided this does not entail material risks to price stability or financial stability.
But this raises two questions: (a) how do you measure ‘economic slack’ and (b) what constitutes a substantial reduction?
So what should the Bank do now? What, if any, forward guidance should it offer to the markets? Will that forward guidance be credible? After all, credibility among businesses and households is an important condition for any policy stance. According to Larry Elliott in the first article below, there are five options.
Articles
Bank of England’s method of setting interest rates needs reviewing The Guardian, Larry Elliott (9/2/14)
Mark Carney set to adjust Bank interest rate policy BBC News (12/2/14)
Forward guidance: dead and alive BBC News, Robert Peston (11/2/14)
What “forward guidance” is, and how it (theoretically) works The Economist (11/2/14)
BOE’s forward guidance 2.0: Cheap talk, or big change? Market Watch (11/2/14)
Bank of England pages
Monetary Policy Bank of England
MPC Remit Letters Bank of England
Forward Guidance Bank of England
Questions
- What data would you need to have in order to identify the degree of economic slack in the economy?
- Why is it difficult to obtain such data – at least in a reliable form?
- Why might the issuing of the forward guidance last July have itself contributed to the fall in unemployment?
- Why is it difficult to obtain such data – at least in a reliable form?
- Why is credibility an important requirement for policy?
- Why may LFS unemployment be a poor guide to the degree of slack in the economy?
- Discuss the relative merits of each of the five policy options identified by Larry Elliott.
It is rising inflation that typically causes problems for countries, whether it is demand-pull or cost-push. However, one country that has not been subject to problems of rising prices is Japan. Instead, this economy has been suffering from the gloom of deflation for many years and many argue that this is worse than high inflation.
Falling prices are popular among consumers. If you see a product whose price has fallen from one day to the next, you can use your income to buy more goods. What’s the problem with this? The Japanese economy has experienced largely stagnant growth for two decades and a key cause has been falling prices. When the prices of goods begin to fall over and over again, people start to form expectations about the future direction of prices. If I expect the price of a good to fall next week, then why would I buy now, if I can buy the same good next week at a lower price? 
But, when next week arrives and the price has fallen as expected, why would I purchase the product, if I think that the price fall is set to continue? The problem of deflation is that with continuously falling prices, consumers stop spending. Aggregate demand therefore declines and economic growth all but disappears. This is the problem that the Japanese economy has been faced with for more than 20 years.
However, the latest data from Japan shows core consumer prices growing faster than expected in December 2013, compared to the previous year. This figure was above market forecasts and was the fastest rate of growth in the past 5 years. These data, together with those on unemployment have given the economy a much needed boost.
Recent government policy has been focused on boosts in government spending, with an aim of reducing the value of the currency (click here for a PowerPoint of the chart). Such policies will directly target aggregate demand and this in turn should help to generate an increase in national output and push up prices. If the price trend does begin to reverse, consumers will start to spend and again aggregate demand will be stimulated.
The future of the economy remains uncertain, though the same can be said of many Western economies. However, the signs are good for Japan and if the recovery of other economies continues and gathers pace, Japan’s export market will be a big contributor to recovery. The following articles consider the Japanese economy.
Japan inflation rises at fastest pace in over five years BBC News (31/1/14)
Benchmark Japan inflation rate hits 1.3% Financial Times, Jonathan Soble (31/1/14)
Japan’s inflation accelerates as Abe seeks wage gains Bloomberg, Chikako Mogi, Masahiro Hidaka and James Mayger (31/1/14)
Japan inflation quickens to over 5-year high, output rebounds Reuters, Leika Kihara and Stanley White (31/1/14)
Japaense inflation rises at fastest pace in over five years at 1.3% in December 2013 Independent, Russel Lynch (31/1/14)
Why Abenomics holds lessons for the West BBC News, Linda Yueh (18/12/13)
Questions
- Why is deflation a problem?
- Using an AD/AS diagram, illustrate the problem of expectations and how this contributes to stagnant growth.
- How will a lower currency help Japan?
- What is the likely effect of a sales tax being imposed?
- Does the fact that unemployment has declined support the fact that consumer prices are beginning to rise?
- What government policies would you recommend to a government faced with stagnant growth and falling prices?
- How important are expectations in creating the problem of deflation?
World markets were taken by surprise by a large rise in Turkish interest rates on 28/1/14. In an attempt to combat a falling lira and rising inflation, the Turkish central bank raised its overnight lending rate from 7.75% to 12%. Following the decision, the lira appreciated by over 3%.
Since the start of this year, the Turkish lira had depreciated by 7.1% and since the start of 2013 by 22.8%. Along with the currencies of several other emerging economies, such as India and Brazil, speculators had been selling the Turkish currency. This has been triggered by worries that the Fed’s tapering off its quantitative easing programme would lead to a fall, and perhaps reversal, of the inflow of finance into these countries; in the worst-case scenario it could lead to substantial capital flight.
Consumer price inflation in Turkey is currently 7.4%, up from 6.2% a year ago. The central bank, in a statement issued alongside the interest rate rise, said that it would continue with a tight monetary
policy until the inflation outlook showed a clear improvement.
The Turkish Prime Minister, Tayyip Erdogan, has been opposed to rises in interest rates, fearing that the dampening effect on aggregate demand would reduce economic growth, which, as the chart shows, has been recovering recently (click here for a PowerPoint of the chart). A slowing of growth could damage his prospects in forthcoming elections.
World stock markets, however, rallied on the news, seeing the rise in interest rates as a symbolic step in emerging countries stemming outflows of capital.
Articles
Turkey raises interest from 7.75pc to 12pc The Telegraph (28/1/14)
Emerging markets forced to tighten by US and Chinese monetary superpowers The Telegraph, Ambrose Evans-Pritchard (28/1/14)
Turkey Gets Aggressive on Rates The Wall Street Journal, Joe Parkinson (28/1/14)
Turkish central bank raises lending rate to 12% BBC News (28/1/14)
Asian stock markets stage relief rally after Turkey rate rise BBC news (29/1/14)
Turkey raises rates to halt lira’s slide Financial Times, Daniel Dombey (29/1/14)
Turkey Rate Increase Stems Lira Drop as Basci Defies Erdogan Bloomberg Businessweek, Onur Ant and Taylan Bilgic (29/1/14)
Fragile economies under pressure as recovery prompts capital flight The Observer, Angela Monaghan (2/2/14)
Data
Main Economic Indicators (including Turkish data) OECD
Data on Turkey, World Economic Outlook database IMF
Turkey price indices Central Bank of the Republic of Turkey
Questions
- Why did the Turkish central bank decide to raise interest rates by such a large amount?
- Why has the Turkish lira been depreciating so much over the past few months? How has this been linked to changes in Turkey’s balance of payments and what parts of the balance of payments account have been affected?
- Why did global stock markets rally on the news from Turkey?
- What will be the impact of the central bank’s actions on (a) inflation; (b) economic growth?
- How has the USA’s quantitative easing programme affected developing countries?
